Op-eds

When American economic pundits refer to "Old Europe," Germany seems to be what they have in mind. The German population is rapidly aging, the country's wage bargaining, labor rules, and product market regulations came from another era, and Germany's days as a Wirtschaftswunder are long gone. Germany has been the slowest growing eurozone economy for the last five years. Unemployment is currently at 10.4 percent (meaning over 4.3 million people out of work). By its own press' and politicians' declaration, Germany has been stuck in a Reformstau—a traffic-standstill on reforms—for more than a decade.

This image is well behind recent developments, and has created undue skepticism about the current changes underway in the world's third-largest national economy. The Red-Green coalition government of Gerhard Schroeder has embarked on an ambitious "Agenda 2010" effort to reform the German economy. Most of it is right in line with the longstanding wish-list of the regular critical reports on Germany from the OECD, the EU, and the IMF (in fact, many of the labor reform proposals were to all appearances copied directly out of the Fund's Article IV report last spring). Even the priorities of which reforms are being tackled first make sense.

Clearly, the greatest problem in Germany is structural unemployment due to the inability to create jobs. And Schroeder's first effort is to address labor market difficulties, particularly huge disincentives to work, in place since the mid-1980s, as well as impediments to matching workers with new jobs. The "Hartz Commission" Report last year was used to attack the dysfunctional Federal Labor Office bureaucracy, barriers to low-wage employment and individual start-ups, and improve matching.

More importantly, this has been followed by proposals to take the critical step of cutting the amount of time a person can claim high unemployment benefits before moving onto welfare. Previously, laid-off older workers could claim up to 80 percent of their wage for up to two full years, and then have a glide path to early retirement, with ongoing generous unemployment benefits until pensions kicked-in. It is only sensible that such German beneficiaries had little incentive to look for new work, and economic research shows that the single biggest institutional predictor of cross-national differences in structural unemployment is duration of benefits. This was the number one reform for Germany on any macroeconomist's agenda, and it will pass this fall.

A reform of the German tax system as well as bringing the date forward for implementing significant income and corporate tax cuts is in the works. Schroeder's main, if not sole, economic reform achievement of his first term in office was a prior reduction in marginal tax rates. Germany, unlike the US, still has average and marginal tax rates sufficiently high to be real disincentives to investment, entrepreneurship, and effort. So this effort, unlike the one in the US, will result in significant supply-side benefits as well as boosting demand. And without large balance of payments deficits and foreign holdings of its government debt, Germany will manage this tax cut without incurring significant interest-rate rises upon recovery to offset its benefits.

So far, the Schroeder government has been less aggressive about taking on the generous welfare state directly, though there are some efforts here as well. In the area of health care, the government hopes to slow rising demand and costs by increasing the amount of co-payments Germans make for services, as well as undertaking some reorganization of how doctors are paid. The government proposals also intend to put off the date of the pension burden exploding by raising the retirement age from 65 to 67.

It is true that these efforts will not be enough to make the current German welfare state sustainable, and that is the source of much of the dismissive commentary of Agenda 2010. Yet, is that the appropriate benchmark for evaluating economic reform in a rich country? All of the major economies are currently doing too little to prepare for the demographic time-bombs in their social security and health systems. Supply-side reforms that raise the rates of labor force participation and economic growth are still beneficial and still improve the medium-term prospects of the economy, even if long-run sustainability is not assured (see Keynes, J.M.). At least they postpone the day of reckoning. Certainly, the Germany economy's prospects after the implementation of the Agenda 2010 reforms will be better than they were after zero reform under the successive Kohl governments of the 1980s and 1990s.

But will they be implemented? It is said Schroeder himself has no real conviction behind his reform effort, and, be that as it may, the opposition parties have a majority in the Bundesrat, the upper house of the German Parliament that has a say on all taxation and many other economic issues. His re-election in September 2002 was by a tiny margin, based in large part on his opposition to American foreign policy and his response to the preceding summer's floods, not on a mandate for economic change. He also leads a Social Democratic Party whose card-carrying membership, if not electorate, is dominated by union officials and members (much as in every democracy, it is the more extreme partisans who dominate internal party politics in Germany, particularly on the left).

By the time this article hits the newsstands, however, the first parts of the agenda—including the critical labor market reforms—will have already been passed, and more will follow shortly. The CDU/CSU-FDP opposition is stuck in a bind, with its only available excuse for blocking such pro-market reforms as cuts in tax rate and unemployment benefits to say, "No, don't do that. Wait three-plus years until the next election, pick us, and then we'll implement something more ambitious," hardly a winning strategy. (CDU Parliamentary Minority Leader Angela Merkel has the look of Bob Dole, circa 1996, when he wanted to run against Clinton but could not block Clinton's middle-of-the-road proposals without undercutting his claim to office—ability to deliver in the legislature.) The FDP is very reluctant to support any Schroeder initiatives, but seeming hypocritical by opposing these proposals it long championed could drive it in the next election below the 5 percent threshold for keeping seats in parliament.

In terms of internal opposition, Schroeder has even a clearer path to economic reform. The left wing of the Social Democratic Party has backed off every time Schroeder has even threatened to force a confrontation over the reform agenda, fearing the Party losing power for an extended period again if there would be a no-confidence vote. Oskar Lafontaine's attempts to rally Social Democrat support around his red flag have repeatedly failed. Schroeder's one party rival from the center, Wolfgang Clement, was cleverly brought into the government as new super-Minister for Economics and Labor, committing him to carrying out the reforms, and being the immediate target of left-wing blame instead of Schroeder. Meanwhile, as the failure of the IG Metall strike in eastern Germany this past summer demonstrated, the unions are losing political support in Germany, at least for their attempts to block change—and Schroeder is happy to let them lose that support. In the tired but entirely apt analogy, Schroeder is Nixon going to China on economic policy, and he has already made the trip.

Perhaps surprisingly to Anglo-American observers, the Green Party coalition partners have been committed to the reform program, and aggressively ahead of it in many ways. This makes sense for the Greens ideologically, with their libertarian streak and their commitment to sustainable inter-generational policies. It also makes sense strategically, since they can then replace the FDP as the swing third party in German politics by being in the responsible center on economic issues (as the FDP was) but delivering on economic reform (as the FDP had not in the 1990s). Worth watching are future initiatives coming from the Green coalition partners to take on corporate welfare and guild-like arrangements that protect inefficient small businesses in Germany.

Even after the successful adoption and implementation of Agenda 2010, there will remain problems in the Germany economy. Beyond the long-run sustainability of the pension and health-care system already mentioned, there is fragility in the German banking system, impediments to retail and trade (which extend far beyond limits on shop hours), and restraints on entrepreneurship that result, as well as the ongoing challenge of raising real incomes and employment in eastern Germany.

Yet, progress in these areas beyond the power or even ambition of the current German government's agenda has been real, too. The German economy, unlike that of say Japan, is quite open to international influences and embedded in multinational obligations and networks, foremost the EU. As a result of Germany's openness, there have been positive developments in the banking system that the government could not resist—notably, the commitment to privatization of the publicly-guaranteed Landesbanken in 2005 and the creation of a "True Sale" securitization fund of German bank assets. German citizens can shop and move their savings throughout the single European market and via the internet, and to a growing (though still limited) degree do so, putting pressure on uncompetitive retailers and financial firms.

Even Germany's long economic legacy of reunification may finally be receding into the background. The initial Faustian bargain in 1990 between the West German unions and the Kohl Government to convert the Ostmark at 1:1, rapidly raise East German wage levels, and transfer huge subsidies eastwards did cause very high and persistent under and unemployment in the neuen Bundeslaender. Over time, however, the younger eastern Germans have benefited from the educational and infrastructure investments made there, have increasingly moved east (or at least south) towards opportunities, and the gap between productivity and wage levels has narrowed. Meanwhile, their parents and grandparents have reached ages to naturally leave the labor force. And the effect of the rise in German interest and exchange rates due to the impact of west-to-east transfers on the public debt has over time dissipated (albeit through the painful means of relative deflation since the euro came into being).

The German economy has revived itself several times over the last century, facing far greater challenges than simply the political sclerosis of a wealthy workforce. Germany is doing it again right now.